Department of Really Unintended Consequences

One important factor that set the stage for last year's financial crisis was the "global savings glut". Massive savings accumulated around the world, particularly in East Asia, which needed to be invested somewhere--that "somewhere" ended up being the US housing market*. Paul Krugman explains:

"The speech, titled 'The Global Saving Glut and the U.S. Current Account Deficit,' offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world."

The Chinese, in particular, provided a lot of capital. This begs the question, "why do the Chinese save so much?" Shang-Jin Wei, writing in VoxEU, has an answer:

"In my recent research paper with Xiaobo Zhang (Wei and Zhang 2009), we hypothesised that a social phenomenon is the primary driver of the high savings rate. For the last few decades China has experienced a significant rise in the imbalance between the number of male and female children born to its citizens.

There are approximately 122 boys born for every 100 girls today, a ratio that means about one in five Chinese men will be cut out of the marriage market when this generation of children grows up. A variety of factors conspire to produce the imbalance. For example, Chinese parents often prefer sons. Ultra-sound makes it easy for parents to detect the gender of a foetus and abort the child that’s not the 'right' sex for them, especially as China’s stringent family-planning policy allows most couples to have only one or two children.

Our study compared savings data across regions and in households with sons versus those with daughters. We found that not only did households with sons save more than households with daughters on average, but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed gender ratio. Even those not competing in the marriage market must compete to buy housing and make other significant purchases, pushing up the savings rate for all households."

His thesis makes intuitive sense: if the relative supply of women decreases, they can demand more on the marriage market. Why settle for a man of modest wealth if a wealthier man is just around the corner? So families with male sons have to amass more wealth if they want to marry those sons off.

Unintended consequences are a reality for policymakers. I wonder if the Chinese officials who first devised the "one-child policy" ever thought it would have an impact on the country's savings rate, let alone global financial markets?

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* This is not intended to "blame" East Asians for the financial crisis. They did not force anyone to make bad loans or underestimate the risks in the housing market. East Asian savings merely provided the capital necessary for the investment boom.

The buck stops somewhere else (try Treasury... or the Fed)

Tyler Cowen says that Congress has opted out of much of the economic crisis. That might not be a bad move on their part:

While Congressional leaders are consulted on the major policies, Congress is keeping its distance, perhaps to minimize voter outrage. This way, Congress can claim credit if a recovery comes, but deny responsibility if the price tag ends up higher than advertised or if banks seem to be receiving unfair benefits from the government.

Of course, while this may be a smart decision for Congress, it might have serious consequences for economic policy in the future:

A Congress that won’t accept much responsibility for the financial bailouts, for example, is unlikely to rise to the occasion when the time comes to make tough decisions on the budget...

On any single policy, the abdication of Congressional responsibility may not be a problem. Sometimes it is good to let the technocrats have their way. In the longer run, though, the United States requires a Congress courageous enough to accept responsibility for potentially unpopular policies. We are moving further away from that every day.

Most economic models typically assume that government will follow some optimal policy. But in reality government is subject to incentives, and in this case Congress doesn't have much reason to get too involved in this crisis. This is why the Federal Reserve (and much of the bureaucracy) is insulated from political pressure: there are tough decisions to be made and no one up for re-election wants to make them.

As Cowen points out, the danger comes about when the elected body doesn't have to make the tough decisions. When the time comes and they have to address the budget deficit--or whether to nationalize part of the banking sector--they won't have built up political capital by leveling with the public about what needs to be done and what can be done.

It may be time for Congress to bite the bullet and, well, actually do something.

An ode to Paul Krugman

I just started a new job, so I haven't had a lot of time to post. But this definitely caught my attention:

For what it's worth, I think Tim Geithner is a very nice looking man.

What can you buy at a 99 cent store?

Stock, apparently:

"Citigroup shares dip below $1"

Did math fail us?

By and large, mainstream economists didn't expect the events of the past 6 months. Many missed the housing bubble; many thought the losses would be contained. In diagnosing this failure, some have focused on the role of "simplistic" or "unrealistic" mathematical models used by economists and financiers to understand how markets work. This month's issue of Wired Magazine, for example, talks about David Li's "Gaussian Copula" function, ominously described as "The Formula That Killed Wall Street":

"His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees."

But was it really the math that let us down? While there are many reasons to doubt the usefulness of the Gaussian Copla, the real failing was one of implementation. After all, math--as used in economics--is just a tool, to be used or misused as people see fit.

Mario Livio, the noted astrophysicist and author of "Is G-d a Mathematician?", argues that while not everything in economics can be successfully modeled with math, there is no reason to stop using it altogether:

"One major reason for the difficulty in making predictions in economics is the fact that many variables of the world of economics — the psychology of the masses, to name one — do not naturally lend themselves to quantitative analysis. Consequently, some crucial aspects cannot be, at least at present, adequately represented in any model.

A second problem arises from the fact that the predictive value of any theory relies on the constancy of the underlying relationships among the different variables. In other words, one needs some assurance that under repeated, completely specified states of, say, consumers, employers, banks, trade unions and so on, the same probability for a given outcome is guaranteed to follow. In the absence of such guarantees, as one critic of mathematical economics has put it, "resembling a science is different from being a science."

Does this mean that we should give up on mathematical economics? In my very humble opinion, absolutely not. Recall that physics, also, was not considered mathematical in Aristotle's time. Yet physics advanced to the point where mathematics is at its very core. The fact that at the moment success in economic forecasts is limited should not impede research in mathematical economics any more than the failure to predict the precise number of spots on the skin of a person with measles should limit medical research into vaccines."

Mathematical models provide useful abstractions that help isolate the effect of specific variables. These models can help clarify our thinking about economic phenomena and provides the field with a consistent vocabulary for debating important questions.

The real story, suggested toward the end of the Wired article, is that when we have a lack of respect for what the models can and can't tell us--when we confuse the model with reality--the whole thing can blow up in our faces.

Gluttonous Americans?

Paul Krugman has an interesting column today looking at the roots of the financial crisis.

The simple story is that people borrowed too much: to buy big houses, fancy electronics and other entrapments of the American dream. But why would people all of a sudden start borrowing so much? The answer is a global savings glut:

"In the mid-1990s... the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

The result was a world awash in cheap money, looking for somewhere to go."

Currency crises like the one in Asia are frightening experiences, and governments who have gone through them are concerned about having enough cash on hand in case something goes wrong. So these East Asian countries took the money they earned by selling exports and amassed it in case of a rainy day. But, of course, that money had to go somewhere, so it went into the US and other economies and fueled an era of cheap borrowing.

This is not a wholly unique story. In the 1970s, oil exporting countries were awash with cash as the price of oil spiked. That money had to go somewhere and it ended up going to projects in Latin American, which helped cause their debt crisis in the 1980s.

The simple answer for our current predicament is that American consumerism compelled people to borrow more. But something real had to happen in order to set this off, like lots of cheap cash flowing into the country.

Is Robert Shiller writing for 30 Rock?

In his new book Animal Spirits, Yale economist and noted behavioral finance expert Robert Shiller looks at the role of human psychology in driving financial markets. Clearly someone at "30 Rock" has read his work:

This is a terrific episode that takes a satirical look at how a financial panic can spread--in this case, by the semi-literate, profoundly crazy character Tracy Jordan.

I recently attended a panel discussion with Shiller at the New School for Social Research, which focused on the current crisis and the degree to which markets became "irrational". Shiller has been challenging the efficiency of financial markets for most of his career, and is likely to gain more prominence in the coming years.

For a non-fictional (but still entertaining) account of the current financial crisis, check out this PBS Frontline documentary posted at Freakonomics.

Taking on the Oligarchs

As the former chief economist at the International Monetary Fund, Simon Johnson has seen his share of crony capitalism in places like Russia and Indonesia. So when he starts warning about the unchecked influence of the financial lobby on the US government, we should all listen.

Given the mistakes made on Wall Street and the sheer size of the financial losses, one would think that Congress would take a tough line on the banks: wipeout shareholders, remove incompetent management and close down the zombies. But as Paul Krugman laments, this is not what the government is doing:

"...what they’re actually doing is underestimating the problem, doing too little too late, and not being open and honest in trying to assess the true cost. The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up. It’s Japan all over again.

And the result will probably be a deeper, long-lasting crisis."

I don't think there's some vast conspiracy of financial managers seeking to control the government. Rather, the influence of the financial industry on the government is more of an emergent phenomenon, the result of the frequent exchange of talent from Wall Street to Capital Hill and back. I don't think Tim Geithner or anyone else is being insincere in their plans for fixing the banks; unfortunately, that doesn't mitigate the result.

28 Business Days Later*

NPR has a good primer on the term "zombie banks", which are banks that are essentially insolvent, but wonder the financial world living off the flesh--er, guarantee--of the government.

These banks represent a huge threat to our financial system, but it's unclear what to do about them. As one of the commentators says, "there's no cure for zombeism".

*Alternate titles:
Night of the Living Banks
Dawn of the TED
Resident Financial
Weekend at Bernie Madoff's (not really a zombie movie, but who cares?)

Change of heart

Add Alan Greenspan to the list of economists favoring some form of temporary bank nationalization. Greenspan was once a disciple of Ayn Rand, Goddess of individualism and libertarianism. Desperate times, I suppose.

(HT: Paul Krugman)

Semantics we can believe in

You know things are bad when a libertarian economist like Alex Tabarrok is warming to the idea of large-scale government intervention into the banking sector. Just one thing: don't call it "nationalization":

"Notice how the term nationalization confuses the issue. First, it suggests government ownership of the banks, which would indeed be a disaster. People in favor of free markets will rightly want to avoid any such outcome but ironically it's the current situation of "wait and see," and "protect the banker," which is likely to lead to an anemic recovery and eventual government ownership. Second, it confuses people on the left who think that nationalization is a way to insure that taxpayers get something on the upside. That idea is a joke - there is no upside. Taxpayers are going to have to pay through the nose but the critical point is that the taxpayers must pay the depositors whom they have guaranteed not the banks.

The debate so far has been framed between a "bailout" and "nationalization." But the public rightly sees the bailout as a way to protect bankers and thus we get pressure for government ownership, which has already happened in part through government control over banker wages. Bankruptcy in contrast is a normal free market procedure, it emphasizes that the firm has failed and current management should be removed. Framing the issue in this way, for example, makes it clear that only the depositors should be protected and under reorganization there should be no control over wages on future management (wages are going to have to be high to get anyone to take on the task). Finally the idea of bankruptcy makes it clear that the goal is to get banks solvent, under new management, and back under private control as quickly as possible."

Like Tabarrok, I generally oppose nationalization efforts in which government operates specific industries. If you think the government could run a car company, for example, try driving around in this:


But what Tabarrok is describing is very different. Since the government already has a stake in the banking sector (through the FDIC, it is the main bank insurer), government-facilitated bankruptcy is much more "free-market" than keeping insolvent, but politically connected banks on life-support. Tabarrok explains:

"What would a private insurance firm do in this situation? Would it pander to the current bank management and carry the zombie banks on its books, hoping and waiting for a miracle? Or would it step in, remove current management, pay off the depositors, reorganize and then sell the banks to recoup its losses? I believe a private insurer would follow the second path, the fact that the government is not yet ready to do this indicates how powerful bankers are in Washington. Thus, given deposit insurance the procedure most consistent with free market principles is bankruptcy, preferably a speed bankruptcy procedure under the auspices of the FDIC which has significant expertise in this field."

Despite the soon to be signed $800 billion stimulus package, the economy will not recover without a functioning banking sector. Bankruptcy won't be pretty, but it's better than being overrun by zombies.

The new Fab Four

Famed photographer Annie Leibovitz photographs the Obama team in the March 2009 issue of Vanity Fair. Here's her shot of the people charged with averting economic disaster:

(Left to Right: Lawrence Summers, director, National Economic Council; Peter Orszag, director, Office of Management and Budget; Timothy Geithner, Secretary of the Treasury; Christina Romer, chair, Council of Economic Advisers)

Let's hope that they, too, are bigger than Jesus.

Also sprach the market

Financial journalists must have telepathic powers. Otherwise, you'd never see articles like this:

Obama spending plan worries US markets

While a large fraction of the economics profession has jumped on-board the fiscal stimulus bandwagon, apparently some investors are less sanguine:

Sinking bond prices are "a reflection of the massive stimulus plan in effect and the likelihood that there is more coming down the road, and the concerns how we will pay for all of this," Kim Rupert, fixed income analyst at Action Economics, told CNN Money.

So there we go. Fiscal stimulus will be bad for the economy, says the market. Or so I thought, until I read this:

Stocks tumble on fresh worries about banks

According to this article:

"At this stage, markets in general and bank investors specifically are really looking to government as the way out," said Jack Ablin, chief investment officer at Harris Private Bank. "Certainly, of just about all of inaugurations that I can recall today's event probably has the not only the symbolic importance but really tangible importance to the stock market." (emphasis added)

So who's right? Financial markets are not monolithic entities, but the product of millions of individual decisions. They are affected by many factors and it's easy (but usually wrong) to construct an ex-post explanation of the day's events.

It seems unlikely that the stimulus plan had much to do with today's events in the market. Obama was sworn in today, but we've known for weeks that fiscal stimulus is coming fast. And it seems equally unlikely that financial markets are suddenly spooked by government debt, particularly with near-zero interest rates allowing the Treasury to borrow virtually for free.

If the market is up tomorrow, what will the headline be?

Forget Tim Geithner, we need Suze Orman at Treasury!

Robert Shiller thinks that some of the stimulus package should go to improving financial literacy in the US:

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. For example, the Treasury announced the creation of an Office of Financial Education in 2002, and President Bush started an Advisory Council on Financial Literacy a year ago. These initiatives are involved in outreach to schools with suggested curricula, and online financial tips. But a much more ambitious effort is needed.

Clearly, many financial errors were made over the past few years (interest only loan, how can I lose?). According to Shiller, this stems from a simple lack of financial knowledge:

A paper by Kris Gerardi of the Federal Reserve Bank of Atlanta, Lorenz Goette of the University of Geneva and Stephan Meier of Columbia University asked a battery of simple financial literacy questions of recent homebuyers. Many of the respondents could not correctly answer even simple questions, like this one: What will a $300 item cost after it goes on a “50 percent off” sale? (The answer is $150.) They found that people who scored poorly on the financial literacy test also tended to make serious investment mistakes, like borrowing too much, and failing to collect information and shop for a mortgage.

Improving financial literacy is a low-cost, potentially high-benefit government program. Strangely, it's not discussed that often. But consider this letter to the Wall Street Journal from Duquesne University economist, Antony Davies (HT: Cafe Hayek):

In the article "Big Slide in 401(k)s Spurs Calls for Change" (page one, Jan. 8), 35-year-old project manager Kristine Gardner says in response to the 44% drop in her 401(k) last year: "There's just no guarantee that when you're ready to retire you're going to have the money." Newsflash: Higher returns are the compensation for incurring risk, and lower returns are the price of safety. Ms. Gardner's 401(k) would have been completely safe had she shifted her investment allocations into money markets. As money markets yield a paltry 1%, Ms. Gardner's real complaint isn't that 401(k)s are unsafe, but rather that financial markets require her to incur risk in exchange for being compensated for incurring risk.

Retirement consultant Robyn Credico claims that "This is the biggest test that the 401(k) plan has seen . . . and it has failed." Au contraire, 401(k) plans have worked exactly as designed. It is the workers (and their retirement consultants) who have failed. There is only one reason why the average person close to retirement should have lost 50% of his 401(k): incompetence. Most workers at that age should have long since shifted the bulk of their 401(k)s into bonds and money markets. The 401(k) is a powerful investment tool but can be dangerous when abused.

If you aren't willing to put forth the effort to learn the principles of investing, that's your choice. But don't hobble the rest of us by asking for government regulation of a tool that works perfectly well just so that you can be spared the effort of figuring out how to use it.

Shiller is much more diplomatic, but the point is the same. A market system is one of profit and loss. You can't have one without the other.

Many, if not most, of the mistakes made over the past few years could have been tempered by better financial education. This does not explain the baffling decisions made on Wall Street and it does not excuse predatory lending practices or government regulators asleep at the wheel. But it's definitely part of the puzzle.

Madame Secretary, your first address to the people:

Where do we go from here?

MIT economist (and 2005 John Bates Clark medal winner) Daron Acemoglu just published an essay on what the economic crisis means for economists and economic theory. It's a terrific piece in both its insight and honesty. In particular, I think two points are worth highlighting. First, Acemoglu writes:

"Our second too-quickly-accepted notion is that the capitalist economy lives in an institutional-less vacuum, where markets miraculously monitor opportunistic behavior. Forgetting the institutional foundations of markets, we mistakenly equated free markets with unregulated markets. Although we understand that even unfettered competitive markets are based on a set of laws and institutions that secure property rights, ensure enforcement of contracts, and regulate firm behavior and product and service quality, we increasingly abstracted from the role of institutions and regulations supporting market transactions in our conceptualization of markets."

It's easy to forget the institutional context of economics, particularly in the developed world.  But one lesson from this crisis is that we cannot simply take institutions for granted.  "Free markets" require institutions to work, including formal institutions (the courts) and informal ones (norms governing business practice).  It's good to think that moving forward we'll pay more attention to these factors.

Second, Acemoglu writes:

"In my opinion, however, the greater danger from an expectational trap and a deep recession lies elsewhere. We may see consumers and policymakers start believing that free markets are responsible for the economic ills of today and shift their support away from the market economy. We would then see the pendulum swing too far, taking us to an era of heavy government involvement rather than the needed foundational regulation of free markets. I believe that such a swing and the anti-market policies that it would bring would be the real threat to the future growth prospects of the global economy. Restrictions on trade in goods and services would be a first step. Industrial policy that stymies reallocation and innovation would be a second equally damaging step. When the talk is of bailing out and protecting selected sectors, more systematic proposals on trade restrictions and industrial policy may be around the corner."

Again, this highlights the difference between "free" and "unregulated" markets.  Any response to this crisis will inevitably result in a larger role for government in the economy.  This is not necessarily a bad thing.  A renewed commitment to proper regulation can strengthen our economic system.  At the same time, interfering with the "free" aspect of the economy--that is, the decentralized system of allocating resources--can reduce prosperity for all.  

The process of economic change can be painful, and certainly there is a role for government in helping to reduce individual suffering by providing social insurance and opportunities for education and retraining.  But it's also the process that creates wealth in society.  The government, by sheer force of will, can keep jobs in Detroit or any other area of the economy.  But it can't make inefficient industries viable again.  It can kick the can down the road, but eventually we'll all be paying for our mistakes.

Capitalism has taken a bit of a beating in the past year.  But we should separate out what we did badly from what we do well.  Let's not throw the baby out with the bath water.

No, dig up stupid!

When I meet people at parties and tell them I'm an economist, they inevitably ask me how we can get out of the economic hole we've dug for ourselves.  The problem is, I'm still a PhD student, and this is a bit above my pay-grade.  So I thought I could provide some context via two of the country's top economists, Paul Krugman and Greg Mankiw.  Krugman and Mankiw are the most eloquent and succinct advocates of the two major plans currently on the table.

At this point it's a forgone conclusion that the government will implement some sort of stimulus plan early in 2009 (eg, in the next month).  With demand faltering, the government has been called upon to pick up the slack.  Unfortunately, that's where the agreement ends (insert "one-armed economist" jokes here).  One idea is fiscal expansion, or more simply having the government buy a lot of stuff: infrastructure, military equipment, healthcare, it almost doesn't matter.  This was the common perspective during the Great Depression, when John Maynard Keynes even went so far as to advocate burying money and paying people to dig it up.

The other plan is to stimulate the economy through tax cuts.  Under this plan, the same amount of money that would have gone into fiscal expansion is used to provide tax rebates.  That way the money gets spent in the economy, but the spending is done by ordinary citizens, who presumably can spend it better than the government.

The crux of the issue is whether the government or private citizens will get more bang for the buck out of the stimulus spending.  There are good arguments on both sides.  Government money will get spent, whereas tax rebates may simply be put in the bank.  Plus, government spending on infrastructure and education will yield long-term benefits.  On the other side, empirical evidence from Christina Romer (recently appointed to head Obama's Council of Economic Advisors) suggests that tax cuts boost economic growth by more than government spending.  Moreover, government spending is channelled through the political process, which means funds may get misallocated.

Of course the two plans are not mutually exclusive.  Krugman has noted recently that while FDR expanded government spending, he also raised taxes to maintain a balanced budget, limiting the effect of the stimulus.  The current prevailing view is that government can (and indeed should) run deficits in a recession in order to stimulate the economy.  So we'll probably get combination of both.  The tough part is figuring out the right mix.

As I watch the ball drop tonight, I'll be thinking about 2009 and the way forward for our economy.  Like I said, this is above my pay grade.  I'm just glad I don't have to make the decision.

Happy New Year!

Ponzi schemes galore!

One of our readers asked for my opinion on Paul Krugman's recent oped, "The Madoff Economy". In it, Krugman wonders if Wall Street hasn't been operating its own Ponzi scheme the past few years:

"Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all."

A bit harsh, but kind of hard to argue with. The whole thing worked as long as people believed that prices could keep going up. The main difference between Wall Street's financial wizardry and a Ponzi scheme is that the latter is deliberately designed to dupe investors, while the former was based on honest (but ultimately inaccurate) measures of risk. There's a difference in intent, and I think that matters a lot.

Arnold Kling adds that Wall Street isn't the only one running a Ponzi scheme:

"Meanwhile, I've been thinking that Madoff is a perfect analogy for the public sector. The government gives people money, which it expects to obtain by taking the money from people in the future. Even the Center on Budget Policy and Priorities, not known as a right-wing organization, sees the U.S. fiscal stance as unsustainable (pointer from Ezra Klein via Tyler Cowen)--in other words, a Ponzi scheme."

Social Security is a good example, since it's based on borrowing money from future Americans to pay current Americans. Then again, Social Security is in no where near that danger that some critics have suggested.

So there you have it. We live in a world of Ponzi schemes, some that work and some that don't, at least not for long.

"Efficient" doesn't necessarily mean "accurate"

Robert Skidelsky has an interesting article in this week's New York Times Magazine Section on the relevance of John Maynard Keynes in today's economy. However, Skidelsky makes an odd mistake for an economist, stating:

"Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable."

That's not exactly what the "efficient market hypothesis" says. Rather, the idea is that market prices contain all relevant information about assets, which means that no one can consistently make above-average financial returns. There's a weak form of the argument (prices reflect all past information about the asset) and a strong form (prices reflect all present and future information about the asset). But no matter which form, the argument does not preclude the possibility that the information is wrong. It simply says that all the available information is reflected in the price. Princeton Professor Burton Malkiel, author of A Random Walk Down Wall Street explains:

"...it is important to make clear what I mean by the term “efficiency”. I will use as a definition of efficient financial markets that they do not allow investors to earn above-average returns without accepting above-average risks.

A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, “Don’t bother—if it were really a $100 bill, it wouldn’t be there.” The story well illustrates what financial economists usually mean when they say markets are efficient.

Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble. Markets can be efficient even if many market participants are quite irrational. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above-average risk-adjusted returns. In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor."

Markets are really, really good at aggregating information. However, if the information is bad, then prices will not reflect the "true" value of goods. In computer science terms, markets can be victims of GIGO.

But does anyone want to buy their cars?

David Leonhardt has a great piece in today's New York Times, explaining why the Big 3 auto manufacturers are really in trouble (hint: it's not simply the labor costs)

"...here’s a little experiment. Imagine that a Congressional bailout effectively pays for $10 an hour of the retiree benefits. That’s roughly the gap between the Big Three’s retiree costs and those of the Japanese-owned plants in this country. Imagine, also, that the U.A.W. agrees to reduce pay and benefits for current workers to $45 an hour — the same as at Honda and Toyota.

Do you know how much that would reduce the cost of producing a Big Three vehicle? Only about $800.

That’s because labor costs, for all the attention they have been receiving, make up only about 10 percent of the cost of making a vehicle. An extra $800 per vehicle would certainly help Detroit, but the Big Three already often sell their cars for about $2,500 less than equivalent cars from Japanese companies, analysts at the International Motor Vehicle Program say. Even so, many Americans no longer want to own the cars being made by General Motors, Ford and Chrysler."

When you exclude the cost of pensions, GM, Chrysler and Ford offer compensation packages that are close to what foreign manufactures pay their American, non-unionized labor.

But the real point is that American's are being asked to bail out companies that don't make products people want to buy. That seems like a bad strategy to me. We can bail these companies out, we can subsidize their production and we can protect them from competition. But unless we require American's to buy their cars* (now there's a Patriot Act for you!) then these companies won't be profitable. I wish Congress would acknowledge that. The real problem is that the Big 3 make sub-par products in the US that are out of touch with consumers.

Until they fix that problem, we shouldn't be bailing them out. You can't help an addict until they admit they have a problem.

*Please note this is sarcasm. I don't think we should do this.

Arnold Kling on the housing collapse

In a very wise move, Congress has asked Arnold Kling to testify about the housing crisis and the crater is has left in financial markets. Kling posted his planned remarks on his blog. He has a much more nuanced understanding of the crisis than many of the louder voices out there:

Speaking as a former financial engineer, I have many regrets about the role played by modern financial methods in this crisis. Rather than speak defensively about financial innovation, I want to offer constructive suggestions for public policy going forward.

I emphatically disagree with the extreme partisan narratives for this crisis. To blame the Community Reinvestment Act for what happened is wrong, To blame financial deregulation for what happened is wrong. The narrative I present in my written testimony describes a combination of government failure and market failure.

I want to focus on how both industry executives and regulators were fooled about the risks in the system. In particular, perverse incentives in bank capital requirements encouraged unsound lending practices and promoted excessive securitization.

Kling also offers 4 lessons from the crisis:

1. Capital requirements matter. Details that are easily overlooked by regulators can turn out to cause major distortions.

2. Securitization is not necessary for mortgage lending. On a level regulatory playing field, traditional mortgage lending by depository institutions probably would prevail over securitized lending. Rather than try to revive Freddie Mac and Fannie Mae, I would recommend that Congress encourage a mortgage lending system based on 30-year mortgages originated and held by old-fashioned banks and savings and loans. This would require instructing the regulators of Freddie Mac, Fannie Mae, banks, and savings and loans to all use the same capital standard for mortgages, one that is based on a stress test methodology.

3. Subsidized mortgage credit is an inefficient tool for promoting home ownership. Unless what you want is home buyers who are buried in debt and speculating on house price appreciation, I recommend that Congress not try to create cheap mortgages and instead use other means to encourage home ownership.

4. Recent financial innovations, particularly credit default swaps, have changed our financial system in ways that current policymakers fail to recognize. Bailouts and rescues are counterproductive in today's financial crisis. Within the financial sector, de-leveraging needs to slow down and the process of shutting down failed institutions needs to speed up. Relative to these necessities, handouts from the taxpayers are a hindrance, not a help.

Definitely read the whole thing.